Why did Persistent stock face a market shock after its biggest M&A deal?

Following the announcement of takeover of German digital IT firm Nagarro over the weekend, shares of Persistent Systems Ltd saw massive weakness on Monday, with the stock prices crashing nearly 10% in early trade and ending the day with shares over 11.3% down on the BSE. The also stock hit a 52-week low at ₹4,291.05 per share. On the other hand, Persistent’s offer price of offer price of €81 per share, a premium of approximately 93.5% over Nagarro’s weighted average share price of the last three months sent the company’s stock zooming on the German stock exchange.

Nagarro SE shares surged over 90% to around €77.50 in early trading on Xetra. Even as Pune-headquartered Persistent held an analyst call on Sunday to provide greater clarity on the deal, not everyone is convinced that the acquisition will have no bearing on the company’s industry-leading revenue growth delivered over the past five years.

What Persistent management says about the deal

At the investor call on Sunday, Persistent’s CEO and CFO clarified how the merger would play out. On the premium being paid to Nagarro’s shareholders, Sandeep Kalra, Executive Director and Chief Executive Officer, said given the legal tax diligence and responses from Nagarro’s management, they believe it to be a reasonable premium for a control transaction. Referring to other private transactions that are happening,” So from our perspective, we believe it is not about buying cheap. It is about buying the right asset. It is about having the right management team capabilities which can help us build for the future. So, it's a value acquisition for us. It is a very complimentary acquisition for us and we are convinced about the value we are paying and about the value we can create for our shareholders," Kalra said during the call.

With 35-40% of the 50% threshold for the open offer already locked in, Persistent sees no hiccups as far as closing the deal goes. "Our interest will be to go as close as possible to the 100% parts of it, so that helps us in terms of the integration and getting the squeeze out much easier. So that will be something which we'll watch out, but 50% I think we are pretty close," said Chief Financial Officer, Vinit Teredesai.

Even though Nagarro’s adjusted EBITDA margin of 13.8% is much lower than Persistent’s 18%-19%, the company’s management believes that cost synergies would lead to maintaining margins and the cultural alignment of the two firms making the integration much easier. With the acquisition funded through a €1.4 billion committed bridge facility from Barclays with no equity dilution or QIP , the drawdown would be determined by the quantum of acceptance. Teredesai said that clarity will emerge over the next couple of months.

“The good part is that both Persistent and Nagarro are good in terms of their cash generation. So, our intent is basically to see some of these money for some of these loans are repaid through the cash generation that will be happening over a period of time,” he said.

Why are brokerages apprehensive?

With the stock seeing heavy selling on Monday opening, analysts are not fully aligned with the value that Persistent’s management sees out of the Nagarro deal. For instance, Nuvama Institutional Equities sees this move sound on business logic, but laden with growth and integration risk. Though the combined entity revenue would now be $2.9 billion and the deal helping Persistent in geographical diversification and capabilities across digital engineering, enterprise application, and deep SAP implementation expertise, they see the acquisition bringing down Persistent’s growth profile.

“Also, integration of an asset of this size, in a relatively challenging geography, such as Europe, is fraught with multiple risks. Until now, PSYS commanded a significant valuation premium by virtue of its ‘risk-free’ ‘industry-leading’ growth profile. With Nagarro acquisition, both these are likely to come under cloud, especially with already rich valuation. Downgrade to ‘HOLD’ mainly on integration risks and high valuation,” the brokerage said in its note.

Analysts at Elara Capital who maintain a SELL on Persistent’s stock see that Nagorra deal aligning with the company goal of diversification from heavy reliance on USmarket, reaching $5bn revenue by FY31, and gaining share in other verticals. Noting Nagarro’s past three years’ performance being weak when compared with Persistent, “

Nagarro reported 5% revenue CAGR in CY23-25 versus 18% USD revenue CAGR for PSYS over FY24-26. Nagarro also trails PSYS on profitability and margins, making the offer price—at nearly 2x the prevailing market price— appear demanding in our view. While valuations on EV/sales basis seem reasonable, we expect the acquisition to dilute the combined entity's revenue growth and profitability profile in the near term,” they said in their note.

Nomura, on the other hand, maintains a NEUTRAL stance and caveating integration key to creating long term value, “We think this acquisition fits Persistent’s goal of reaching $5 billion of revenue by FY31E with a higher presence in Europe. However, given the large size of the transaction (~67% of its existing size), a seamless execution is critical to create value for the shareholders in the medium to long run,” the Nomura note said.

Equirus Capital which now has a REDUCE call on Persistent Systems sees Nagarro's current market price reflecting the company’s current investors pessimism about its growth profile, terming the premium being paid by Persistent as expensive.

While Motilal Oswal Financial Services remains bullish, and reiterating BUY rating said that limited customer overlap and complementary geographic presence will also create a reasonable cross-sell opportunity for Persistent. “Our area of caution is around the services mix and margins. While ERP strengthens Persistent's end-to-end portfolio, it also increases exposure to a relatively mature and competitive services segment where differentiation can be harder than in digital engineering,” the MOFSL note said.

While noting Persistent’s guidance for stable margins and Year-1 EPS accretion, “We therefore think integration execution, realisation of cost synergies, margin improvement, and leadership retention will remain the key monitorables over the next few quarters,” the note added.